How Evergrande found itself on the wrong side of China's regulators

BEIJING — Chinese developer Evergrande made little progress toward complying with Beijing’s crackdown on real estate debt — until it was too late for investors who poured money into its offshore bonds, now worth at least $19 billion.

Worries about the giant developer’s ability to repay its debt and a total of $300 billion in liabilities have put global investors on edge. Beyond the company itself, there are worries about a potential spillover into the rest of China’s real estate industry or economy.

A closer look at Evergrande revealed a company with many of the same problems as others in the Chinese property sector, but didn’t act as quickly to respond to government rules aimed at resolving those issues.

Evergrande has failed to meet several payment deadlines since September, and the latest was on Oct. 11 for interest owed on one of its U.S. dollar-denominated bonds. That brought its total missed payment to $279 million since last month, according to Reuters.

While the developer had taken on debt for years, its latest problems really came after tighter regulation in the last two years, analysts said.

China’s central bank on Friday said most real estate developers had stable operations, and called Evergrande a unique case in which the company “blindly” diversified and expanded. There was little indication a full-on rescue plan was on its way.

Here’s how the world’s most indebted property developer ended up in such dire straits:

Chinese authorities met with 12 real estate developers in August 2020, and asked them to reduce their reliance on debt. Evergrande was among those at the meeting, state media said.

The report described a “three red lines” policy, which hasn’t been officially announced. State media describe the “red lines” as three specific balance sheet conditions developers must meet if they want to take on more debt. The rules require developers to limit their debt in relation to the company’s cash flows, assets and capital levels.

Last summer, all 12 of the developers at the meeting had crossed at least one of the red lines, said Julian Evans-Pritchard, senior China economist at Capital Economics.

One year later, Evergrande and Greenland were the only companies of the original dozen that had still crossed at least one of the red lines, Evans-Pritchard said in a Sept. 22 report. As of the end of June, he said Greenland had crossed one, while Evergrande had breached all three red lines.

In contrast, “among the top 30 [developers], less than a third exceed any of the limits, compared with over two thirds a year ago,” he said. “Even firms that are not officially subject to the rules have generally complied.”

Evergrande warned investors of default in late August. Just days earlier, China’s central bank and other authorities told the company’s executives in a rare meeting to resolve their debt problems.

“The problem this entire industry faces is the entire model relies too much on finance,” said Zhang Yingji, senior fellow at Chinese real estate research institute ICR.

He said the restrictions on how quickly developers can expand come as ensuring affordable housing is a major part of China’s economic development plan for the next five years.

The average price for a residential home in China — typically an apartment — more than quadrupled between 2001 and 2019, while that of a new house in the U.S. rose 80% during the same time, according to official data from China and the U.S.

The price surge came even as Beijing began in 2016 to promote a slogan that “houses are for living in, not speculation.” It was an effort to control a property market that many likened to a bubble.

However, in the next few years, Chinese developers continued to take on debt, particularly in overseas markets.

Between 2016 and 2020, the industry’s value of offshore U.S. dollar bonds grew by 900 billion yuan ($139.75 billion) — that’s nearly two times the growth of 500 billion yuan in onshore yuan bonds, according to Nomura.

Evergrande was by far the leader in overseas debt issuance, accounting for six of the 10 largest offshore U.S. dollar-denominated bond deals by Chinese real estate companies between 2016 and 2021, according to Dealogic.

As of the first half of this year, Evergrande held 19% of U.S. dollar-denominated high yield bonds among Chinese real estate companies — the largest share, worth $19.24 billion, according to Natixis.

Next in line by overseas bond share were Kaisa, Yuzhou, China Fortune Land Development and Guangzhou R&F Properties, the data showed. All four of these companies crossed at least one red line, with China Fortune and R&F crossing all three, according to Natixis data analyzed by CNBC.

Hopson Development Holdings, which is reportedly set to acquire part of Evergrande, did not cross any of the red lines and ranks 28th by asset size, Natixis data showed.

Hopson declined to comment. Evergrande did not respond to a CNBC request for comment.

Like many developers in China, Evergrande sold apartments to individual consumers before the properties were completed. This allowed the company to generate cash, while taking out loans to develop the properties.

Over the last decade, the value of Evergrande’s properties under construction rose so quickly that it far exceeded the value of the company’s completed projects as well as what the company was able to sell.

By 2020, Evergrande had 1.26 trillion yuan ($195.89 billion) worth of projects under construction. But that was about 70% more than the properties the company was able to sell that year, at 723.2 billion yuan. Only about 148.47 billion yuan of projects were actually completed.

The value of properties under development accounted for just over half of Evergrande’s total assets, ticking up to 54.7% in the first half of this year, up from 54.3% at the end of last year.

Keeping up with such a high ratio of construction projects became unsustainable once the new regulation kicked in and affected Evergrande’s ability to obtain financing.

“Financial institutions have already curtailed their direct exposures to Evergrande over the past two years,” Moody’s analysts said in an Oct. 11 note.

They said there was a drop in the company’s borrowings from banks, trust companies and other financial firms to 393.9 billion yuan at the end of June, down sharply from 604.7 billion yuan at the end of 2019.

Many of Evergrande’s projects lie in smaller Chinese cities, where economists say there is an oversupply of housing, compared to China’s largest cities, where there is a housing shortage.

The company is also in a tougher situation than other developers because of its heavy use of supplier commercial bills – tradeable contracts for paying suppliers and construction contractors, S&P Global Ratings analysts said in a Sept. 20 note.

“Evergrande’s contracted sales have fallen more than other issuers in the sector that have experienced distress,” the report said.

Without sufficient financing, it is harder to keep up construction and other assets that can be sold, S&P said. “This is shutting down Evergrande’s most important source of cash flow: contracted sales of its property projects.”